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U.S. financial markets will continue to suffer destructive boom-bust cycles until something is done about international funds flows. The U.S. needs to break the chain of causality that runs from Chinese currency policy through Federal Reserve inaction to those recurring asset-price bubbles and their inevitable, painful ends. Regulation has little power in this. The only practical hope lies with a change in Fed policies. Sadly, Fed leadership shows no sign of even considering the right changes.

The problem starts with China and other countries that promote exports through currency manipulation. Because these nations strive to enhance their global competitive edge by holding the values of their currencies cheap to the dollar, they buy huge volumes of dollars on foreign-exchange markets. China alone has purchased $800 billion a year, on average, during the past 10 years—although its net purchases have been vanishingly small in the past 12 months. Because China and these other countries cannot sell these dollars without undermining their currency strategies, they invest them in U.S. markets. There, because the Fed has failed to neutralize their effect on markets, or "sterilize" them, in central-bank jargon, these funds have fueled three dangerous asset bubbles since globalization first gained momentum in the 1990s.

The first of these, the Asian Contagion, got its start not from China but from what were then called Asia's Tigers -- prominent among them Malaysia, South Korea, Taiwan, Singapore, Hong Kong, Thailand, and Indonesia. These nations realized that cheapening their currencies' values would promote exports and accelerate growth. They accumulated vast hoards that they placed in U.S. Treasuries and like securities. Because the Fed did nothing to offset the effect of these funds flows, liquidity in U.S. markets soared during this time.

This excess pushed up asset prices and drove investors to search for ways to put the money to work. Ironically, and surely unknowingly, they turned their attention to the place from which the liquidity had emerged. The bubble that was forming in the U.S. spread to Asia and lifted asset prices there faster than even those fast-developing economies could sustain. A collapse was all but inevitable.

The seeds of the Tiger bust were planted in 1994, when China decided to enter the export competition and precipitously devalued its yuan more than 50% against the dollar. The yuan's drop powerfully undercut the Tigers' export advantage. Starved for credit and undercut by China, their inflated asset markets collapsed, and their economies plunged into steep recessions. Governments fell. It took from mid-1997 to late 1999 for their economic situations to stabilize.

By the late 1990s, the flow of dollars to the U.S. from Asia, now mostly China, had resumed. Again the Fed failed to counteract the impact; American liquidity grew faster than fundamental economic needs. The difference between fundamental needs and actual growth was, in fact, much the same as earlier in the decade. Awash with funds once again, private investors sought new places to make gains.

The Fed should simply guide money-creation according to the economy's fundamental needs, draining liquidity when foreign flows create an excess and injecting it when events create a shortfall.
Tim Foley for Barron's

This time they focused on the exciting computer technologies and Internet applications that were then emerging. The massive supply of funds filtering through financial markets pushed up these stock prices until their valuations reached ridiculous levels. The end came not from China, which held its admittedly destabilizing policies constant throughout, but, inadvertently, from the Fed. Worried in 1999 about a modest rise in inflation, but not liquidity excesses, policy makers engineered what must have seemed to them moderate monetary restraint. But even modest restraint devastated bloated financial markets that by then had grown dependent on Fed excesses.

In the new century, China still rigidly held the yuan cheap by purchasing dollars, and again, the Fed failed to sterilize their effect. After 2002, liquidity again built faster than the U.S. economy's fundamental needs. This time, investors skipped both Asia and the Internet and focused on residential real estate. As the price bubble expanded beyond economic reality, the Fed, again inadvertently, brought on the crash. Still ignoring liquidity from abroad, the Fed pursued a monetary tightening that, in a purely economic context would have elicited a moderate response. But, as before, the least constraint crushed bloated markets.

There is always the hope that China and other emerging economies will change their policies. But if history is any guide, such a change is highly unlikely. After almost two decades of American pressure to revalue the yuan upward, it remains almost 20% cheaper to the dollar than it was before its 1994 devaluation.

If China is unlikely to make a substantive move, control of this cycle must fall to domestic means, through a change in monetary policy. The Fed should simply guide money-creation according to the economy's fundamental needs, draining liquidity when foreign flows create an excess and injecting it when events create a shortfall. Such a posture not only could break this chain of causality, but it could do so without asking the Fed to neglect its other economic concerns, particularly inflation. It is an easy adjustment that requires little more than diligence on the part of the Fed.

Some are tempted to end the boom-bust problem by stopping international fund flows and globalization altogether. Though such an effort might return finance to the well-ordered patterns of the 1950s and 1960s, it would do so at a considerable cost in growth and living standards. Globalization, for all its documented ills, has also added considerably to world prosperity. Surely, it would be better to find remedies that alleviate the strains of globalization and allow nations to secure its benefits.

MILTON EZRATI is senior economist and market strategist for Lord Abbett. This article is drawn from his latest book, Thirty Tomorrows, due out this fall from Thomas Dunne Books.